Challenges Facing Commodity
Futures Market Participants: The Anti-Speculation Cycle, the RORO Environment, & Position Limits. By Hilary Till
PROFESSOR SCOTT IRWIN of the University of Illinois has argued that there is a reasonably predictable “anti-speculation cycle” due to periodic bouts of inflation and deflation in commodity prices (Figure 1). Therefore, market participants have an obligation to periodically explain the economic role of futures trading and the role of speculators in these markets. This will be the main task of this article. In addition,we discuss two other challenges facing market participants: the impact of the Risk On / Risk Off (RORO) environment in managing commodity risk, and the prospects for the imposition of commodity position limits.
Economic Role of Hedgers & Speculators What is the economic role of hedgers and speculators in the commodity futures markets? We will start by noting that the terms, “hedging” and “speculation,” are not precise, as discussed in Till (2012a, 2012b). A commodity merchant who hedges inventories creates a “basis” position and is then subject to the volatility of the relationship between the spot price and the futures price of the commodity. The merchant is, in effect, speculating on the “basis.” The basis relationship tends to be more stable and predictable than the outright price of the commodity, which means that the merchant can confidently hold more commodity inventories than otherwise would be the case. What futures markets make possible is the specialization of risk- taking rather than the elimination of risk. Who would take the other side of the commercial
hedger’s position? Answer: A speculator who specializes in that risk bearing. The speculator may be an expert in the term structure of a futures curve and would spread the position taken on from the commercial hedger against a futures contract in another maturity of the futures curve. Or the speculator may spread the position against a related commodity. Till and Eagleeye (2004, 2006) provide examples of both intra-market spreading and inter-market spreading, which arise from such risk-bearing. Alternatively, the speculator may detect trends
resulting from the impact of a commercial’s hedging activity, and be able to manage taking on an outright position from a commercial because the speculator has created a large portfolio of
unrelated trades. Presumably, the speculator will be able to dampen the risk of an outright commodity position because of the diversification provided by other unrelated trades in the speculator’s portfolio. In this example, the speculator’s risk-bearing specialization comes from the astute application of portfolio theory.
What futures markets make possible is the specialization of risk-taking rather than the elimination of risk
What then is the economic role of commodity speculation and its “value to society”? Ultimately, successful commodity speculation results from becoming an expert in risk bearing. This profession enables commercial entities to privately finance and hold more commodity inventories than
Figure 1: The Anti Speculation Cycle Price Consumer Complaints
Producer Complaints Time Source: Irwin (2012), Slide 46.
otherwise would be the case because they can lay off the dangerously volatile commodity price risk to price-risk specialists. Those commercial entities can then focus on their area of specialty: the physical creation, handling, transformation, and transportation of the physical commodity. Cootner (1961) wrote that in the absence of being able to hedge inventories, a commercial participant would not rationally hold “large inventories … unless the expected price increase
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